JAKARTA/KUALA LUMPUR, July 16 For decades,
Indonesia has shipped out tanker loads of raw palm oil for
processing into higher value cooking oil and margarine in
Rotterdam, Mumbai and Kuala Lumpur.

Now, the world's No. 1 producer of the edible oil is seeing
a more than $2.5 billion wave of investment to build a refining
industry that will double its capacity and mean it could supply
the entire needs of Asia's top food consumers - India and China.

The transformation - driven by Indonesia's move to slash
export duties for processed oil last October - will heat up
competition with rivals such as Malaysia and send ripples
through the palm oil market as new supply pressures prices of
traded refined products such as palm olein, used as cooking oil.

A Reuters survey of 30 firms operating in Indonesia - from
the world's biggest listed palm oil firm Wilmar to
conglomerate Unilever - shows plans to nearly double
refining capacity to 43 million tonnes of palm oil, or 80
percent of total world output.

"The government is sending a clear message - to survive, you
need a refinery. So the palm oil firms are putting their money
out and following the big guys in the industry who have already
done so," said Thomas Mielke, an analyst at industry publication
Oil World.

"There is the threat of over capacity. But palm oil firms
with the whole supply chain behind them, we are talking about
having plantations to mills and ports, will be the kings."

Gleaming silver storage tanks standing ten-storeys' high
are becoming a feature of Indonesia's landscape as more
refineries spring up, threatening the stranglehold on processing
held by neighbouring Malaysia, the No.2 palm oil producer.

At a newly built refinery near Jakarta, staff wearing face
masks and hair caps work on conveyor belts carrying boxes of
margarine and cooking oil.

The $249-million Marunda plant run by PT SMART was
launched before the tax change and Indonesia's top palm oil firm
plans to spend a further $200 million on new refining capacity
despite the infrastructure issues it faced building Marunda.

PT SMART will be one of the biggest investors in the sector
along with Wilmar and unlisted Musim Mas, which plans to spend
$860 million, according to the survey.

Government officials in Malaysia and Indonesia say these
firms had aggressively lobbied Jakarta to cut duties on refined
palm oil to half those levied on crude.

Much of the expansion is led by companies owned by powerful
tycoons in Indonesia. SMART is controlled by the family of Eka
Tjipta Widjaja, who created a palm oil empire from his humble
start selling biscuits from a rickshaw.

Foreign firms are not far behind. Commodities trader Louis
Dreyfus formed joint ventures with planters such as
Singapore-listed Kencana Agri to build refineries in
Indonesia.

Until now, Indonesia had focused on expanding plantations.
Oil palms cover roughly 8.2 million hectares (20.3 million
acres), an area about the size of the island of Ireland, and
their cultivation is often blamed for rainforest destruction.

BRING DOWN PRICES

Palm oil, the world's most traded and consumed edible oil,
is used mainly as an ingredient in food such as biscuits and ice
cream, or as a biofuel.

But with more Indonesian supplies coming on stream, more
inefficient refining operations could get shut.

On the flip side, greater competition could cut final
product costs to the benefit of consumers in India and China,
where food inflation is a constant concern for policy makers. So
far this year, palm olein prices have fallen nearly 10 percent
on higher Indonesian supplies.

Under its refining plans, Indonesia could meet domestic
needs of around 10 million tonnes annually as well as supplying
the combined 20 million tonnes of edible oil imports required by
top buyers China and India.

Indonesia's crude palm oil output - estimated at 23 to 25
million tonnes in 2012 - looks set to be outpaced by the planned
increase in refining capacity in the next two years.

That means some palm oil firms may build refineries run at
lower capacities until more edible oil supply comes in.

DBS analyst Ben Santoso said latecomers to Indonesia's
refining business could see margins squeezed to $40 per tonne
from $70, although still healthier than its main competitor.

"The capacity of some of these smaller companies will turn
idle. But let's not forget, Malaysia's refining margin is just
$9 to $10 a tonne," he added.

MALAYSIA AND INDIA FEEL THE PRESSURE

As Indonesia rushes to build refineries, vegetable oil
refiners in Malaysia and India are feeling the pressure.

"I am having sleepless nights. I have closed down 30-40
percent of my factory and I hope it won't be more," said a
refiner in Malaysia's Johor state.

Malaysia currently has 22.9 million tonnes of refining
capacity, with only about three quarters of it used last year
down from a record 90 percent in 2005.

And this shows in exports. Malaysia's combined refined palm
olein exports in April and May dropped 19 percent to about 1
million tonnes from a year ago, according to cargo surveyors.

Indonesian palm olein shipments jumped 55 percent in the
same period to nearly 600,000 tonnes.

Malaysia could respond by removing a tax free export quota
for crude palm used to feed the overseas factories of some firms
or replicate Indonesia's tax system to level the playing field.

Both options are politically risky with an election on the
horizon, as they entail taxing crude palm oil that in Malaysia
is mostly produced by small farmers who make up the bulk of the
electorate and come under the tax free export quota.

To capitalise on Indonesia's export tax changes, Malaysia's
top planter Sime Darby is building an Indonesian
refinery. KL Kepong and IOI Corp are
expected to follow suit.

India, the world's largest edible oil buyer, has been
fending off industry calls to hike the import duty on refined
palm oil to stem the inflow of cheap cargoes from Indonesia for
fear of stoking inflation.

India currently imposes a 7.5 percent tax on refined palm
oil from Indonesia. But it is still $15 cheaper a tonne to
import Indonesia's processed palm oil than to ship in crude and
refine it, traders say.

"Before Indonesia changed the export taxes, a lot of
refiners were expanding their factories," said Ashok Sethia,
President of the Solvent Extractors Association of India.

"Now all those plans have been abandoned," he added.

Refined palm olein used to make up below 5 percent of total
imports and now accounts for nearly 20 percent of 883,410 tonnes
shipped into India in May.

This will make it hard for India to preserve its processing
capacity of 15 million tonnes.

SENSITIVE POLICY

Palm oil is just part of Indonesia's efforts to attract
investment and squeeze more from its agricultural and mineral
resources, a policy that has sometimes backfired.

In May, Indonesia imposed a 20 percent tax on some metal ore
exports and told miners to submit plans to build smelters or
process ore domestically. The government says this should help
Indonesia earn more revenue, although a union said miners had
laid off more than 200,000 workers since the ruling.

Taxes on palm oil were introduced in 1994 with the aim of
ensuring palm-based cooking oil was available in the developing
country of more than 200 million people.

But the system fell apart when the rupiah currency collapsed
during the Asian financial crisis in the late 1990s, prompting
palm oil firms to export more and triggering food riots at home.

With this in mind, export taxes on crude palm oil were kept
much lower than on refined oil to shore up domestic supply. That
frustrated the processing industry with many firms thinking of
exiting Indonesia in 2010 and 2011, said Sahat Sinaga, executive
director of the Indonesian Vegetable Oil Refiners Association.

"If the government did not take action, we would have just
remained a crude palm oil exporter and earned much less," said
Sinaga."
($1 = 3.1955 Malaysian ringgit)
(Chew Yee Kiat reported for the story from SINGAPORE; Editing
by Ed Davies)